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U.S.: The Twin Deficits Are Back--and As Dangerous As Ever

July 07, 2002

The twin deficits have returned. A ballooning federal budget shortfall and a widening trade gap are towering, Godzilla-like, over the nascent recovery. These two deficits, if unchecked, could cause trouble for the financial markets, the U.S. dollar, monetary policy, and U.S. growth.

The U.S. shouldered these twin burdens before. In the mid-1980s, the federal and trade deficits mushroomed, with serious consequences. Interest rates were higher than they should have been, and massive foreign inflows boosted the dollar to a level that clobbered U.S. exporters. Consequently, U.S. businesses had little incentive to invest. Spending on new equipment was flat from the end of 1984 until the start of 1987.

A similar outcome could spell danger for the economy, which is looking vulnerable right now. New allegations of accounting fraud at WorldCom have further heightened investor uncertainty and pushed stock indexes to new lows for the year. Consumers are feeling less confident about the recovery and job prospects. Real gross domestic product may have grown at less than a 2% annual rate in the second quarter. And while the Federal Reserve Board kept interest rates unchanged at the June 25-26 meeting, they warned the lift from "inventory investment and the growth in final demand appear to have moderated."

Economists are betting on a turnaround in capital spending to give the recovery the extra oomph needed to power it into 2003 and beyond. But less foreign money coming into the U.S. and a bigger government presence in the bond market means funds for new capital projects will not be as plentiful. Access to cheap money fueled the New Economy boom. But thanks to the twin deficits (charts), financing the economy may not be as easy in the future as it was in the 1990s.

THE 180-DEGREE TURN in Washington's finances has been particularly stunning. The budget for fiscal 2002, which will end on Sept. 30, is on track to post its first deficit since 1997. Total spending from October to May is up 10% from the same period the year before, while revenues have sunk by 11.7%. The Congressional Budget Office projects a shortfall well above $100 billion, and private forecasters put the total at more than $150 billion in both 2002 and 2003, a sharp reversal from the $127 billion surplus for 2001. Indeed, the $277 billion swing would be the largest on record.

But while some of the rise in outlays and fall in revenues is due to the economy's cyclical slowdown, some is structural, created by permanent tax cuts and new defense and security priorities. According to the CBO, a rise in unemployment insurance is leading the spending jump. Once the economy is strong enough to generate a healthy pace of new jobs, these expenditures will shrink. But Washington will spend more on the war against terrorism, homeland security, and perhaps a military initiative against Iraq. As a result, Washington's outlays will continue to rise, but growth probably will slow back down to the 4% to 5% pace of the last few years.

AT THE SAME TIME, the White House wants to make a permanent and significant cut to revenues. To be sure, in this fiscal year, much of the loss in tax revenues was the result of layoffs, pay cuts, fewer exercised stock options, and a fall in capital gains. But the CBO estimates that between "$35 billion and $40 billion of the $161 billion decline in total receipts through May, 2002, resulted from changes in tax laws." The stimulus plan now before Congress will reduce tax rates for upper-income households even further. So even when the economy gathers momentum, Washington won't see a commensurate pickup in tax revenues.

The dangers to the economy from these fiscal woes are twofold. First, to fund outlays, Washington will have to draw more deeply on the credit markets. That means the U.S. Treasury will take funds away from corporate borrowers. This crowding-out could result in higher interest rates paid on all types of borrowing, from U.S. bonds to business loans to mortgages.

Second, Washington has lost its ability to respond rapidly to economic swings. A major reason for the mildness of last year's slump was the tax rebate quickly enacted by the White House and Congress. Those checks were possible because the government had piled up cash during four years of surpluses. Without that cushion, the government will not be able to react nimbly if the economy stumbles.

THE OTHER DEFICIT clouding the expansion's future is the trade gap--along with its much broader cousin, the current-account deficit, which also includes the balances for portfolio income and foreign transfers. The gaping current-account deficit reflects both the 1990s boom in investment and consumption and the foreign funds that helped to finance it.

Now, though, fewer foreign funds are available just when the U.S. needs them the most. U.S. external financing requirements ballooned in the first quarter, as the current-account deficit hit a record $112.5 billion. The gap may swell further as the year progresses. The April trade gap increased to $35.9 billion after averaging $31.6 billion per month during the first quarter. A wider trade deficit will subtract a percentage point or more from second-quarter GDP growth.

The longer-term problem is that less abundant foreign financing could limit the U.S. expansion. Foreign financing in the late 1990s allowed the U.S. to consume more than it produced, and it helped provide investment funds for tech startups and productivity-enhancing systems at nontech companies. From 1995 to early 2001, foreign net purchases of stocks and corporate bonds increased almost tenfold, and foreign direct investment rose sixfold.

But in the past year, foreign purchases of stocks and bonds are down 24%, and foreign direct investment is off 63% (chart). Geopolitical risks and mistrust of Corporate America take some blame for this reduced inflow. And a key victim is the dollar, down 12% vs. the euro and 10% vs. the yen since late February.

The dollar will decline further, but it should do so in a gradual and orderly fashion. Why? U.S. prospects for growth, productivity, and profits remain better than those in either Japan or Europe. Unit labor costs in Europe are rising, while in the U.S. they are falling. A lower dollar will make the country's producers more competitive, lift the earnings of its multinationals, and reduce its dependence on foreign funds by narrowing the trade gap.

The price of that narrowing, however, could be slower growth in U.S. investment and consumption, especially if Uncle Sam skims off more private savings, which could lift interest rates. The U.S. weathered the effects of the twin deficits in the mid-1980s. But given the new uncertainty of the stock market, battling them this time around could be tougher.